WE CAN'T TAX OUR WAY OUT OF THE ENTITLEMENT CRISIS

August 21, 2008

Given the hearty support Barack Obama received in Europe last month, he must have noticed the surprise and skepticism among some Germans when he asked that Europeans contribute more for defense. Many Europeans argue they cannot afford such an additional expenditure. They are right. And therein lies a cautionary tale for the United States, because continental Europe has been following something like Obama's plans for spending and taxes, says R. Glenn Hubbard, dean of Columbia University Business School.

The spending shortfalls in Social Security and Medicare are large. Obama has indicated he would solve the long-run solvency of Social Security (a good thing), but ruled out benefit cuts to achieve solvency and looked first to payroll taxes (a bad thing), says Hubbard:

According to the Congressional Budget Office, left unchecked, Social Security and Medicare spending would, after a generation, consume about 10 percentage points more of gross domestic product (GDP) than it does today.

Simple arithmetic suggests that with this much more of GDP eaten up by the two programs, all federal taxes on average would have to be raised by more than 50 percent to make up the shortfall.

Research by economists Eric Engen of the Federal Reserve Board and Jonathan Skinner of Dartmouth suggests that such a tax increase would reduce long-term GDP growth by about a full percentage point.

This is no small matter: Think of it as reversing all of the gains in our long-term growth rate from the productivity boom of the past 15 years.

Now it is easy to understand European concerns about higher defense spending, says Hubbard. Large entitlement budgets almost certainly cannot be financed with growth-chilling taxes alone. Spending on other areas, including defense but also education, research, etc., must also be adversely affected.